by Gabriel Alliluyev for the Austrian Economics Center
Persistent pains and still the same old prescriptions… Almost. Because things seem to be changing, very slowly but noticeably, as the traditional recipes prove wrong. Let´s have a quick look into the Outlook in 10 small bites.
1. After many years recommending an ultra-expansionary monetary policy as the silver bullet for the crisis, finally (and inevitably) the OECD recognizes that per se the latter is absolutely insufficient (if not counterproductive) as a remedy not only in the long-run, which is obvious, but also in the short-run. For the first time ever since QE was implemented, there is some honest stocktaking of the negative consequences of this policy in terms of bank profitability, unduly risk taking and induced delays to close the last indebtedness cycle (by the way also magnified by an irresponsible and protracted monetary spree before 2007).
2. Nonetheless, the recognition of the mistake is still incomplete. According to the Outlook, the lack of effectiveness of QE is mainly traced to her solitude, since it has not been appropriately matched by the necessary fiscal discretion and structural reforms. The Keynesian view on monetary policy still permeates the analysis and masks the basics: with the household savings rate still very low by historical standards in many countries and a high –private and public- debt burden, it is impossible to generate the financial capacity for a more intense and healthier deleveraging process. Furthermore, the flattening of the yield curve does nothing but to discourage savings and incentivize the demand for credit for those agents whose indebtedness ratios were still low.
3. The supposed rationale of this persistent need for expansionary policies is given by the substantial estimated cyclical slack (also called output gap, or the difference between the observed GDP and the theoretically potential one). Nevertheless, most proxies of potential output rely on a “smoothed” measurement of observed GDP over a number of years. To the extent that the latter is distorted by such a prolonged period of cheap money, the trend GDP is probably much lower than estimated, whereby a good deal of that cyclical slack does not exist in reality. Put in other words, the economy is converging towards a new long-run equilibrium where, absent the monetary stimulus, the non-inflationary GDP growth is considerably more subdued than two decades ago. We will come back to this problem afterwards.
4. A collective fiscal expansion, primarily based on an increase of public investment, is predicated on the grounds of boosting growth by alternative means to monetary policy, This would be possible, according to the report, thanks to the enhanced fiscal space that the low interest rates have created. It is understood, implicitly, that these interest rates should remain abnormally low for a long period or at least until the investment projects are executed, for this policy not to swell the net discounted liabilities of the public sector.
5. I find really striking how this recommendation downplays the importance of the rocketing public debt stocks in most OECD members. Under more neutral interest rates and undistorted risk premia, a number of countries could find it more profitable to channel their increased fiscal space in amortizing debt, since it is really complex to identify a massive set of socially worthy investment projects in such a brief period. Why is this alternative not contemplated? Or put in other words, why does the report ignore the beneficial effects of public debt sustainability on growth and confidence?
6. Beyond this essential problem, there is also a very relevant institutional difficulty. The OECD recommendation seems to be designed in an ideal world where no fiscal rules are enforced and countries estimate their fiscal space in line with the OECD. Nonetheless, the euro area has her own fiscal rule. It is not a good one, it is plagued by methodological and conceptual shortcomings, but it is a working rule. The Stability Pact has been subject to a very lax interpretation since the outbreak of the crisis and my sense is that every possible avenue to slow down fiscal consolidation has already been exploited. It could be a nice discussion whether we need a new rule, better designed and more transparent and credible, but in her absence, what we do not definitely need is a generalized suspension of the current one, since the consequences in terms of the market reaction and the incentives for discipline could be disastrous. On the contrary, there is not a proper reflection in the Outlook about desirable changes in the composition of public budgets, shifting away from unproductive expenditures –such as those associated with the operation of general governments, or unjustified subsidies- towards a less distortive taxation on savings or more effective and targeted fiscal incentives for innovation.
7. More light than in other occasions is shed on the need for structural reforms, in view of the trend productivity weakness that represents a serious obstacle for medium-term growth. My first reaction is to warmly welcome this reinforced emphasis, but also to recall that one –if not the main one, in the current circumstances- driver of feeble productivity growth is QE and, more in general, ultra expansionary monetary policy. This has been demonstrated in recent research (see, for example, Borio (2015)) and the multiple transmission mechanisms range from distortions in relative prices to disincentives to factor reallocation (both labor and capital) from less productive companies to more innovative and competitive sectors. Thus, asking for more efforts on the structural front would probably be more consistent with defending a more proactive withdrawal of the pervasive monetary stimulus.
8. It sounds really bizarre how the report disentangles the productivity problem from the elusive business investment recovery. Whereas business investment might be affected by a low demand in some cash-strapped companies, this is not necessarily so for the bigger ones, for which financing is fully available and the degree of capacity utilization, high in many cases. For those ones, their expected productivity growth, compared with the future cost of financing, is a key explanatory variable for their physical and intangible investment decisions. Thus, a good package of structural reforms, taylored to the specifities of each country could be able not only to revive productivity, but also to drive demand up (through private investment) and make the economy shift to a long-term equilibrium with a more robust income creation.
9. According to the Outlook, structural reforms must care also about their short-run distributive consequences., as well as their impact on the longer run. This can only be considered as a fallacy. Reforms that do not harm one or other social group in the short-run are very rare and this kind of prescription leads to inaction. Structural reforms must be addressed to their long-run targets, such as dynamizing the private sector or removing obstacles to productivity growth, since this will also improve income distribution (away from market dominant firms and towards more industrious and responsible agents).
10. The document transpires some faith in future wage increases to re-ignite demand growth and increase inflation. So far these have been muted for a number of reasons but they are expected to rev-up as the labor markets gradually heat. Nonetheless, real wages must stick to productivity for playing a socially efficient role. In many countries real wages are already growing above productivity because of deflation or very low inflation. If the aim is to anchor inflationary expectations on central banks targets, the least damaging way to do so may be to lower those targets or widen the bands in view of the international commodities deflation. If the goal is just sparking aggregate demand and growth, private investment is a social win-win, as explained above.
As you see, the lyrics of this song still need much rethinking. Good news is, however, that the music has begun to sound differently and somewhat better… We will see for how long.
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